13 May 2024 Derivatives

Linklaters completes review of Credit Derivatives DC process, appointed by ISDA

Linklaters has completed an independent review of the structure and governance of the Credit Derivatives Determinations Committees (DCs). The review, requested by the International Swaps and Derivatives Association Inc. (ISDA), covers the composition, functioning, governance and membership of the DCs. The report makes several recommendations about the changes that could be made to improve the structure of the DCs and is now available on the ISDA website for public consultation.

The recommendations made by Linklaters include the following:

General observations

  • A determinations process is needed for credit default swaps and provides market stability as well as reducing costs.
  • The existing DC process has been effective overall but there are some areas in which it could be improved.

Independence

  • Concerns about conflicts of interest remain in some quarters, including on the part of regulators. Although it is not suggested that decisions have been influenced by conflicts, if an issue were to arise in the future, it could seriously disrupt the credit derivatives market and so is an area of risk.
  • The point can be addressed in two ways:
  1. DCs having an independent chairman and up to two other independent members (with appropriate experience and qualifications); and/or
  2. DCs having a facility to refer decisions (especially difficult decisions) to an independent panel for resolution.

Representation and transparency

  • It would be desirable for there to be more transparency in the DC process (for example, enhanced rules about the information that must be included on the DC website and how quickly it appears).
  • The DCs Rules should be required to give reasons for all material decisions. The amount of detail required will depend on the decision.
  • There is a strong argument that, within certain parameters, non-DC members should be able to advance arguments in favour of a particular outcome (although not necessarily anonymously).

Procedural clarity

  • The DC Rules are unclear about some important issues, such as what information must be provided to ask a DC to determine whether a credit event has occurred.
  • It should be made clear that the DCs’ role is to decide the issues referred to them on the evidence available and does not include finding the evidence in the first place.

Governance

  • There should be a governance body with responsibility for overseeing the way the DCs carry out their functions.
  • It would report periodically to the market, obtain feedback from market participants and have responsibility for making any changes to the DC Rules. It would potentially also be able to require DC members’ compliance with the DC Rules regarding conflicts to be audited.

Funding

  • The existing funding model (which involves the dealer members of the DCs bearing all the costs) is unfair and should be replaced by a new funding model.
  • This would ideally involve a transaction-based levy, although the exact mechanism requires detailed consideration.

Following the public consultation on the Linklaters recommendations, ISDA will work with its members to propose specific changes to implement any measures that receive broad public support. ISDA will then recommend these solutions to the DCs, which are solely responsible for agreeing and implementing any changes.

The Linklaters team was led by partner Simon Firth.

Simon Firth, commented:

“This has been the most detailed review of the DC process since the DCs were established in 2009. It’s reassuring that there is a broad consensus that the process has generally been effective and contributes to market stability. However, I also believe that there is an opportunity to make a number of improvements to ensure that the DCs continue to serve the needs of the market.”

Find the full report on ISDA’s website here.